Download Less Than Zero: The Brave New World of Negative Interest Rates

OUTLOOK
Economic Data and Commentary
August 2016 Volume 13 Number 8
Less Than Zero: The Brave New
World of Negative Interest Rates
LESS THAN ZERO: THE BRAVE NEW WORLD
OF NEGATIVE INTEREST RATES............. 1–7
SELECTED NEGATIVE YIELDS ON
SIX-MONTH GOVERNMENT BONDS.......... 4
EFFECTIVE FEDERAL FUNDS RATE . . ......... 5
INTEREST RATES AND
ECONOMIC INDICATORS...........................8
COBANK REPORTS SECOND
QUARTER FINANCIAL RESULTS........... 9–10
ABOUT COBANK......................................9
As recently as two years ago, many economists viewed negative rates as
forbidden territory – much the way some aviation experts prior to 1947
predicted that any airplane trying to break the sound barrier would explode.
Then, in 2014, the European Central Bank and several smaller European
financial authorities sent key interest rates into negative territory in an
effort to spur economic growth. Japan followed earlier this year, and in
early August, fears that the Bank of England was about to go negative
precipitated a wave of cash hoarding on the part of British savers.
Two years into the experiment, it’s time for a more balanced view, says
Wellesley College economist Daniel Sichel. While negative rates have hardly
proved to be a panacea for the slumping global economy, neither have they
wrought the sort of chaos and disaster that naysayers predicted. Far from
representing a descent into monetary madness, negative rates are simply
the latest practical step by central bankers trying everything in their toolkit
to put their economies on a positive course, says Sichel.
A former economist with both the Federal Reserve and the Treasury
Department, Sichel spoke with OUTLOOK about the logic behind negative
rates, why he believes they’re a remote (but not impossible) option for the
United States, and how analysts will ultimately look back on this remarkable
period in the history of monetary policy.
OUTLOOK: What are negative interest rates, and why do they represent
such a departure from the norm?
Daniel Sichel: The financial arrangement that most people are used to
is: If you borrow money, you pay interest. And if you make a deposit in a
bank, implicitly lending the bank money for a time, they pay you interest.
With negative interest rates, you actually pay the bank for the privilege of
having your money there. Central bankers see it as an extension of their
tools to stimulate the economy. But from the perspective of the public,
it seems like a really radical, unusual, unnatural step, almost an Alice in
Wonderland scenario.
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OUTLOOK: How did we get to this situation?
This Month’s Expert
Daniel Sichel has been
a professor of economics
at Wellesley College in
Massachusetts since 2012,
focusing on macroeconomics, productivity
and economic growth, technology, and
economic measurement. Before joining
the Wellesley faculty, Dr. Sichel served at
the Federal Reserve Board in Washington,
where he helped guide the Fed’s forecast
and analysis of the U.S. economy. He
also served as assistant to the chair of the
Airline Transportation Stabilization Board,
established to support the aviation industry
after the attacks of September 11.
From 1993 to 1995, Dr. Sichel served
as a research associate at the Brookings
Institution, where he wrote the book The
Computer Revolution, about information
technology and economic growth. From
1995 to 1996 he served as Deputy
Assistant Secretary for Macroeconomic
Policy at the Treasury Department. He is
a Research Associate with the National
Bureau of Economic Research and serves
on the Advisory Committee of the Bureau of
Economic Analysis. He earned his bachelor’s
degree and a master’s in public policy from
the University of Michigan and his Ph.D. in
economics from Princeton.
DS: In the fall of 2008, the financial crisis that started with the Lehman
Brothers collapse quickly spread throughout the U.S. financial markets and
around the world. The United States was shedding 700,000 to 800,000
jobs per month, unemployment was shooting up, and the economy was
contracting very quickly. The Federal Reserve and central banks in other
countries began lowering interest rates to try to stimulate economic activity.
And by the end of 2008, the Fed had lowered the federal funds rate to zero
and essentially kept it there until last December, when they raised it just a bit.
For most of that time, economists referred to the “zero lower bound” – the
idea being that rates really couldn’t go below zero. What’s happened in the
last couple of years is that countries in the Eurozone, along with Japan,
Sweden, Switzerland, Denmark, and Hungary (though not the United
States) have actually set the rate a little bit negative, ranging from a tenth of
a percent below zero to three-quarters of a percent below zero.
OUTLOOK: What are they hoping to accomplish?
DS: They’ve done this as another effort to stimulate their lagging
economies, following the logic that lower interest rates make it less expensive
for individuals or businesses to borrow and spend or invest. To them, it’s just
another step in a long process of lowering interest rates.
What’s so surprising to people is that everyone had thought that zero
really was the “lower bound.” For decades, economics textbooks said you
couldn’t have negative interest rates because businesses and individuals
would stop depositing money and just stockpile cash. But these central
banks have shown that zero is not the bottom – it’s possible to push
interest rates below zero.
OUTLOOK: In a practical sense, what institutions are actually being
affected in those countries?
DS: So far, negative rates have been largely restricted to interactions between
central banks and the large banks that deposit money with them. Banks are
required to keep cash reserves to be able to meet requests for withdrawals.
If you’re a large bank, having cash physically stored at your bank is hugely
expensive. You need a place to store it that’s safe from fire, damage, and
theft. So they deposit the cash at central banks such as the European
Central Bank until they need to use it – just as American banks do with the
Federal Reserve. And, since the financial crisis, banks reserve balances have
increased dramatically, to levels well beyond what they are required to keep.
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Policymakers have a specific objective here. They’re
trying to encourage those banks not to leave their cash
sitting around, but to make more loans to businesses
and individuals, where they can actually earn positive
interest – and also stir growth.
Traditionally, central banks pay interest on those reserve deposits. With
negative rates, the situation is reversed, and banks are paying the central
bank to hold their money. Policymakers have a specific objective here.
They’re trying to encourage those banks not to leave their cash sitting
around, but to make more loans to businesses and individuals, where they
can actually earn positive interest – and also stir growth. At some point,
banks could decide negative rates are too expensive, and invest in the
infrastructure needed to store the money themselves. But at the moderately
negative rates we’ve seen so far, they haven’t reached that point.
OUTLOOK: Will negative rates filter down to businesses and retail bank
clients?
DS: Banks have so far been reluctant to pass negative rates along to
their customers, for fear of the bad publicity it would cause. In most of
these countries, retail rates have stuck at very low numbers, but haven’t
gone below zero. Of course, if central banks push negative rates much
lower, that could change.
OUTLOOK: But most retail consumers don’t have to worry about the
expense of storing billions of dollars. Wouldn’t they just keep their money
in a safe deposit box, or under the proverbial mattress?
DS: Even for individuals, there are inconveniences to holding cash. Two
thousand dollars sitting around your house could be stolen, misplaced or
damaged. And a stack of cash is problematic for transactions in the modern
economy. I can’t use money in the desk drawer to buy something online
from Amazon. So I have a checking account, a credit card, a debit card. It’s
possible interest rates could go a bit negative even at the retail level, and
people would hold onto those accounts for convenience.
In a sense, that’s already happening. People who open checking accounts
today are getting essentially no interest, maybe 0.1 percent. And many
pay fees, for example, if they keep a low balance, or for using ATMs. If you
factor the all-in costs, many people are already receiving the equivalent of
a negative interest rate, even if it’s not referred to as such. The big question
with negative rates is, how long and how low would they have to go before
people decide enough is enough and start to hold more cash? That’s
something we don’t know.
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SELECTED NEGATIVE YIELDS ON SIX-MONTH
GOVERNMENT BONDS
Denmark
-0.41%
European Central Bank
-0.58%
Japan
Sweden
Switzerland
Source: Investing.com (as of 8/8/16)
OUTLOOK: Have negative rates succeeded in their mission of
stimulating economies in the Eurozone and elsewhere?
DS: Policymakers and economists would say they’ve have
been useful, though perhaps less than they initially hoped,
because financial markets have taken negative rates as a
-0.23%
sign that something really bad must be happening in these
economies. That perception is more dangerous than the reality.
-0.73%
For example, the money banks are paying central banks to store
their cash has had only a small impact on their profits. But the
-0.80%
impression that they are being hurt badly has had an adverse
effect on European bank stocks. Poor stock performance in turn
makes it that much harder for banks to lend aggressively, which is what
negative rates were supposed to accomplish in the first place.
I’d put a lot of this on poor communication. Central bankers could do a
much better job of educating investors and the public that going from
0 percent interest to negative .25 percent isn’t really much different from
going from 1 percent interest to .75 percent. In both cases, it’s a drop of
25 basis points, more of a continuum than an earth-shattering departure.
Negative rates are just another tool in policymakers’ toolkits.
OUTLOOK: What are the chances we could see negative interest rates in
the United States?
DS: I see that as very unlikely – not for philosophical reasons, but because
our economy is performing well in comparison with those that have
established negative rates. What would have to happen is we slip into
another recession, and by that I don’t mean one or two quarters of slightly
negative growth. I think it would take a more significant downturn for the
Federal Reserve to implement negative interest rates.
Instead, the consensus outlook for the U.S. economy is for steady,
continued GDP growth. We’ve been running at about 2 percent growth for
the past five years, which by historical standards is pretty sluggish, but it’s
still growth, and a far cry from recession. In fact, the Fed these days is very
much focused on when it’s going to raise rates further. That’s really the
current conversation between the Fed and financial markets.
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EFFECTIVE U.S. FEDERAL FUNDS RATE
7%
OUTLOOK: What makes our situation so
different from Europe?
6%
5%
4%
3%
2%
1%
0
2000
2005
Blue shading indicates recessions
Source: St. Louis Fed
2010
December
2008
2015
DS: That’s a great question, and one
where you could get a lot of different
answers from a lot of different economists.
Certainly, there are many ways in which
the U.S. economy is more dynamic than
Europe’s, with more entrepreneurship and
fluid financial markets. But if you think
about the degree to which the U.S. has
outperformed those countries, I think policy
choices have been the main reason.
The Federal Reserve has been very aggressive about stimulating the
economy. Europe, with the Greek debt crisis and events that followed,
quickly pivoted to austerity, trying to restrain government spending.
In the U.S. we had a milder pivot to austerity starting in 2010–2011,
with all of the budget crises and battles between President Obama and
the Republican Congress. That was not helpful, but it was modest in
comparison to steps taken in Europe. We all think, oh, my gosh, the
economy is so sluggish, why are things improving so slowly? But in
comparison to Europe, we’re doing much better.
OUTLOOK: Why did Fed Chair Janet Yellen say earlier this year that she
wouldn’t take negative rates off the table for the United States?
DS: I think Yellen was starting an education campaign, letting financial
markets know that negative rates are a viable tool that central banks can
use in certain scenarios. So if we do go that direction, people would be more
familiar with the concept. Three or four years ago people would have said
it could never happen. Now, economists and Fed bankers are saying, if the
economy performs exceptionally poorly, this would be a tool they could use.
Especially since there’s a growing feeling that they cannot get too much more
bang for the buck out of other measures, such as quantitative easing.
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OUTLOOK www.cobank.com
Central bankers could do a much better job of
educating investors and the public that going from
0 percent interest to negative .25 percent isn’t
really much different from going from 1 percent
interest to .75 percent.
OUTLOOK: What would negative interest rates in the U.S. mean for
agriculture and other industries?
DS: If I am correct that it would take a serious recession to bring negative
rates to the United States, the problem wouldn’t be negative rates, but the
recession itself. That would be bad for agriculture and every other sector,
especially since the economy is still so vulnerable. There are plenty of
people who haven’t gotten back everything they had before the financial
crisis and the Great Recession.
If we do endure another recession, negative interest rates might be seen as
a positive development, a sign that the Federal Reserve was taking steps to
stimulate the economy. Of course, a lot would depend on how well the Fed
had informed financial markets, the financial press, and the public about that
possibility. That’s why I mentioned Janet Yellen’s education campaign earlier.
If that campaign succeeds to the point that people are comfortable with the
idea that negative rates won’t cause a sonic boom and wreck the economy,
they might be greeted as a necessary step. If it hasn’t succeeded, people
would see negative rates as a really strange place to be. So Yellen and her
colleagues have some work to do to get the public used to the idea, in the
unlikely event we go that direction.
OUTLOOK: How do negative rates affect international trade?
DS: They tend to drive down the value of a currency, which makes a
country’s exports cheaper for international customers. That’s one way in
which negative rates in the U.S. might actually help industries such as
agriculture that depend heavily on exports. There’s probably been some
benefit along those lines for countries that already have negative rates. But
there’s also been a lot of global market volatility, so it’s hard to isolate out
specific effects in a really concrete way.
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OUTLOOK www.cobank.com
Negative rates tend to drive down the value of a
currency, which makes a country’s exports cheaper
for international customers. That’s one way in which
negative rates in the U.S. might actually help industries
such as agriculture that depend heavily on exports.
OUTLOOK: How will we ultimately look back on this era of negative rates –
as an historical anomaly, or the new normal?
DS: For any economist, the standard answer to a question like that is: My
crystal ball is broken. But I’ll give it a shot. Sometime in the next 10 years
the economy will return to what we think of as more normal performance.
Productivity growth will pick up, and the economy will start to perform the
way we were accustomed to having it perform before the financial crisis.
We have slower population growth than during the 20th century and so the
overall economy will be growing more slowly, but something like 2.5 to 3
percent GDP growth per year would be much better than we have now.
Today we look back at the Great Depression as an anomaly, but many
economists of that period thought of stagnation as the new normal. A lot
of people were terrified at the end of World War II that as government war
spending wound down the economy would slip back into depression. But
in fact, we were at the start of an historic boom. Bad things do happen in
financial markets. And the historical record shows there’s slow recovery
following deep financial crises. But full recovery will come. And we will
have learned an important lesson, that negative interest rates aren’t the
end of the world.
Commentary in Outlook is for general information only and
does not necessarily reflect the opinion of CoBank. The
information was obtained from sources that CoBank believes
to be reliable but is not intended to provide specific advice.
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OUTLOOK www.cobank.com
Interest Rates and
Economic Indicators
HEDGING THE COST OF FUTURE LOANS
A forward fixed rate is a fixed loan rate on a specified balance that can
be drawn on or before a predetermined future date. The table below lists
the additional cost incurred today to fix a loan at a future date.
The interest rate and economic data on this page were updated as
of 7/31/16. They are intended to provide rate or cost indications
only and are for notional amounts in excess of $5 million except for
forward fixed rates.
FORWARD FIXED RATES
Cost of Forward Funds
KEY ECONOMIC INDICATORS
Gross Domestic Product (GDP) measures the change in total output of the
U.S. economy. The Consumer Price Index (CPI) is a measure of consumer
inflation. The federal funds rate is the rate charged by banks to one another
on overnight funds. The target federal funds rate is set by the Federal Reserve
as one of the tools of monetary policy. The interest rate on the 10-year U.S.
Treasury Note is considered a reflection of the market’s view of longer-term
macroeconomic performance; the 2-year projection provides a view of more
near-term economic performance.
ECONOMIC AND INTEREST RATE PROJECTIONS
Average Life of Loan
Forward
Period
(Days)
2-yr
3-yr
5-yr
10-yr
30
5
5
5
5
90
5
8
8
8
180
5
9
12
12
365
9
17
24
22
Costs are stated in basis points per year.
US Treasury Securities
2016
GDP
CPI
Funds
2-year
10-year
Q3
2.20%
2.20%
0.41%
0.65%
1.49%
Q4
2.20%
2.20%
0.44%
0.78%
1.66%
2017
GDP
CPI
Funds
2-year
10-year
Q1
2.20%
2.20%
0.48%
0.94%
1.83%
Q2
2.30%
2.40%
0.52%
1.10%
1.95%
Q3
2.20%
2.30%
0.54%
1.23%
2.07%
SHORT-TERM INTEREST RATES
This graph depicts the recent history of the cost to fund floating rate loans.
Three-month LIBOR is the most commonly used index for short-term financing.
3-MONTH LIBOR
YIELD
Source: Insight Economics, LLC and Blue Chip Economic Indicators
6.00%
5.00%
4.00%
3.00%
2.00%
PROJECTIONS OF FUTURE INTEREST RATES
Daily Rate
The table below reflects current market expectations about interest rates
at given points in the future. Implied forward rates are the most commonly
used measure of the outlook for interest rates. The forward rates listed are
derived from the current interest rate curve using a mathematical formula
to project future interest rate levels.
1.00%
30 Day Moving Avg.
0.00%
06
1/
1/
06
1/
5/
06
1/
9/
07
1/
1/
07
1/
5/
07
1/
9/
08
1/
1/
08
1/
5/
08
1/
9/
09
1/
1/
09
1/
5/
09
1/
9/
10
1/
1/
10
1/
5/
3
3
2
2
4
2
4
4
5
5
5
6
3
6
1
1
10 1/11 1/1 1/1 1/1 1/1 1/1 1/1 1/1 1/1 1/1 1/1 1/1 1/1 1/1 1/1 1/1 1/1
5/
9/
9/
5/
9/
1/
1/
5/
5/
9/
1/
5/
1/
1/
9/
5/
1/
1/
9/
IMPLIED FORWARD SWAP RATES
Years
Forward
3-month
LIBOR
1-year
Swap
3-year
Swap
5-year
Swap
7-year
Swap
10-year
Swap
Today
0.78%
0.86%
0.98%
1.11%
1.25%
1.43%
0.25
0.87%
0.88%
1.00%
1.13%
1.27%
1.45%
0.50
0.87%
0.91%
1.04%
1.17%
1.31%
1.48%
0.75
0.92%
0.96%
1.07%
1.21%
1.35%
1.52%
1.00
0.92%
0.98%
1.09%
1.24%
1.37%
1.53%
1.50
0.97%
1.03%
1.17%
1.32%
1.45%
1.61%
2.00
1.03%
1.08%
1.22%
1.37%
1.50%
1.64%
2.50
1.10%
1.15%
1.30%
1.44%
1.56%
1.69%
3.00%
3.00
1.16%
1.22%
1.38%
1.51%
1.62%
1.74%
2.50%
4.00
1.31%
1.37%
1.53%
1.64%
1.72%
1.83%
5.00
1.48%
1.54%
1.65%
1.78%
1.83%
1.90%
RELATION OF INTEREST RATE TO MATURITY
The yield curve is the relation between the cost of borrowing and the time
to maturity of debt for a given borrower in a given currency. Typically,
interest rates on long-term securities are higher than rates on short-term
securities. Long-term securities generally require a risk premium for
inflation uncertainty, for liquidity, and for potential default risk.
YIELD
TREASURY YIELD CURVE
4.00%
3.50%
2.00%
1.50%
July 2016
1.00%
3 Months Ago
0.50%
6 Months Ago
0.00%
3m 6m 1
2
3
5
10
15
30
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OUTLOOK www.cobank.com
CoBank Reports Second Quarter
Financial Results
About CoBank
CoBank is a $125 billion cooperative bank
serving vital industries across rural America.
The bank provides loans, leases, export
financing and other financial services to
agribusinesses and rural power, water and
communications providers in all 50 states.
The bank also provides wholesale loans
and other financial services to affiliated
Farm Credit associations serving farmers,
ranchers and other rural borrowers in 23
states around the country.
CoBank is a member of the Farm Credit
System, a nationwide network of banks
and retail lending associations chartered
to support the borrowing needs of U.S.
agriculture, rural infrastructure and rural
communities. Headquartered outside
Denver, Colorado, CoBank serves customers
from regional banking centers across the
U.S. and also maintains an international
representative office in Singapore.
For more information about CoBank, visit
the bank’s web site at www.cobank.com.
CoBank has announced its financial results for the second quarter and
first six months of 2016. The bank’s net income for the second quarter
increased 5 percent to $243.3 million, compared to $232.3 million in
the second quarter of 2015. For the first six months of 2016, net income
was $486.6 million, a 5 percent increase from $464.6 million in the same
period last year. The increases in earnings primarily resulted from higher
net interest income, partially offset by higher provisions for loan losses,
increases in operating expenses and lower overall noninterest income in
the 2016 period.
Net interest income for the second quarter was $345.9 million, a 12
percent increase compared to $309.4 million in the same period last year.
For the first six months of the year, net interest income increased 9 percent
to $682.8 million, compared to $624.6 million for the first six months of
2015. The increases in net interest income were primarily driven by higher
average loan volume and increased earnings on balance sheet positioning,
somewhat offset by spread compression in the bank’s loan portfolio due to
continued strong competition and a higher cost of short-term debt.
Average loan volume rose 14 percent in the second quarter to $92.4 billion,
from $81.1 billion in the same period last year. For the first six months of
2016, average loan volume rose 13 percent to $91.1 billion, from $80.9
billion in the same period last year. The increases resulted from higher
levels of borrowing from affiliated Farm Credit associations, agricultural
cooperatives, other food and agribusiness companies, rural electric
cooperatives, and rural communications service providers.
“We’re pleased with both the quarterly and year-to-date
results of our business, including solid growth in our
portfolio across all of our operating segments,” said Robert
B. Engel, CoBank’s chief executive officer. “In addition
to loan growth, CoBank’s profitability, credit quality and
liquidity all remain strong. Most importantly, the bank
Robert B. Engel
continues to fulfill its mission by providing dependable
credit and financial services to rural industries.”
At quarter-end, 0.63 percent of the bank’s loans were classified as adverse
assets compared to 0.71 percent at March 31, 2016. Nonaccrual loans
decreased to $115.4 million at June 30, 2016 from $212.8 million at March
31, 2016. The bank’s allowance for credit losses totaled $628.3 million at
quarter-end or 1.32 percent of non-guaranteed loans when loans to Farm
Credit associations are excluded.
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OUTLOOK www.cobank.com
Capital levels remain well in excess of regulatory minimums. As of June
30, 2016, shareholders’ equity totaled $8.6 billion, and the bank’s
permanent capital ratio was 14.9 percent, compared with the 7.0 percent
minimum established by the Farm Credit Administration (FCA), the bank’s
independent regulator.
During the quarter, the bank redeemed at par plus accrued interest all of
its outstanding 7.875 percent subordinated notes due in 2018, totaling
approximately $405 million. The bank also issued $375 million in preferred
stock. The new Series I non-cumulative perpetual preferred stock has a
fixed dividend rate of 6.25 percent until October 1, 2026, after which the
dividends will accrue at a floating rate.
David P. Burlage
“We continue to monitor the capital markets and capital
regulations in order to optimize the effectiveness, quality
and cost of our third-party capital, which enhances our
lending capacity and our ability to serve the borrowing
needs of our customers,” said David P. Burlage, CoBank’s
chief financial officer.
At quarter-end, the bank held approximately $30.5 billion in cash and
investments and had 200 days of liquidity, which was in excess of FCA
liquidity requirements.
Engel noted that, despite strong financial results in the first half of the year, the
bank continues to face challenges that have the potential to negatively impact
earnings and overall financial performance over the balance of the year.
“CoBank’s margins remain under pressure due to historically low interest
rates as well as intense competition in the banking and finance industries
for the business of our customers,” Engel said. “In addition, it is possible we
will see deterioration in credit quality as a result of lower commodity prices,
a stronger dollar and other economic and geopolitical events or trends that
impact many of our borrowers.
“Nonetheless, we remain highly confident in the overall financial condition of
CoBank and in our ability to meet the needs of our customers. We continue
to focus on building the long-term strength of the organization and on
fulfilling our vital mission in rural America.”
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